Many people don’t realize all the taxes involved in a stock portfolio without an efficient tax wrapper. By an efficient tax wrapper, I mean any tax-preferred vehicle like a retirement account, college savings fund, charitable fund, life insurance cash value, and others.
An investment portfolio can be comprised of individual stocks, individual bonds, treasuries, cash, money market accounts, certificates of deposit, exchange-traded funds, mutual funds, crypto and many others. Because equity investments (company ownership) are taxed differently than fixed income (debt instruments), the broad categories I’d like to focus on are equity-based mutual funds and stocks. Let’s explore the taxes involved in these investment portfolios and how to optimize your portfolio taxation.
Capital Gains
When you sell a stock at a gain, that is known as a capital gain. This can occur intentionally on your part, by going in and selling a particular security. It can also happen without your explicit knowledge in the case of mutual funds. Mutual funds are diversified baskets of stocks with a specific objective. The fund objective is often something along the lines of maximizing income, long-term appreciation, or tracking a specific index.
Let’s say, for instance, we have a fund with an objective to track the S&P 500. The S&P 500 is the 500 largest publicly traded stocks in the United States, but the index is not constant. In fact, an average of about 20 changes are made to the S&P 500 each year with over a third of the stocks having turned over between 2014-2023. Every time there is a change to the index, your portfolio is selling and buying more stock, which could result in a capital gain even in years of negative investment performance. The more actively you manage your portfolio, the more taxes will drag down your returns. There are two types of capital gains to be aware of.
If you buy a stock or fund and sell it within the same year, you will be subject to short-term capital gains. Short term capital gains are taxed like ordinary income, with the top federal rate at 37%. Please note that any time I mention federal rates, state taxes may also be applicable depending on your own state’s laws. While not always avoidable in funds, you may avoid paying this elevated rate by holding stocks for at least a year before selling.
Long-term capital gains are more tax-favored than short-term. They are the result of holding an asset for at least a year before selling. The top federal tax bracket for long-term capital gains is currently 20%, about half that of short-term capital gains.
Dividend Income
Many companies with publicly traded stocks will pay out dividends, which are a share of the profits or reserves that the company chooses to distribute to investors. Dividend income makes up an average of about 2% of the S&P 500’s annual growth, with many companies paying 1-2% and some paying over 4%. So, if you hold a stock and never cash it out, there is a good chance that you are still paying taxes on dividend income. There are two types of dividend income: qualified and non-qualified.
A stock dividend is qualified if it is a scheduled dividend paid from earnings or profits of a United States corporation or qualified foreign corporation, and it meets a holding period required by the IRS. The holding period terms are a little complicated, but most people can satisfy the terms by holding the stock for at least a few months. Qualified dividends are taxed at the same preferred rate as long-term capital gains, which is a top federal rate of 20%.
Non-qualified dividends are any dividends that do not meet the definition of qualified dividends. They are taxable as ordinary income at a maximum federal rate of 37%.
Medicare Contribution Surtax
The Medicare Contribution Surtax is designed to fund the Medicare system by only taxing those considered high income. The tax threshold, created in 2012, included no adjustments for inflation. As a result, more people owe this tax each year. If you have Modified Adjusted Gross Income above $200,000 ($250,000 if married) and you have investments, you’ll likely be subjected to an additional 3.8% in taxes on your investment gains and income.
How To Optimize
A potential way to optimize your portfolios and minimize the impact of taxes is to invest within a tax-advantaged vehicle according to your goals. For example, if your goal is to save for retirement, consider maximizing a retirement account for that goal before investing in a standard investment account.
If you’ve maximized all your different tax-advantaged vehicles in accordance with your goals, we can minimize excess taxation in a standard investment account by:
- Keeping rebalancing frequency down to once per year.
- Investing in passive funds that have low turnover of stocks.
- Selling some securities at losses to offset gains.
- Sticking with your strategy over the long term.
There are many ways that taxes can eat into your investment returns. It is critical to understand the various taxes you pay in investment accounts and how to mitigate them to get the most out of your money. Consider working with a qualified tax professional and financial professional if you need support maximizing after-tax returns over time.